Anti-dilution protection

Anti-dilution protection is a provision of investor agreements that assures the investor that the value and extent of his ownership share will remain even after subsequent investment rounds.

If the number of shares increases, the share of any previous shareholder or investor will decrease. Anti-dilution protection is a contractual provision designed to limit the possibility of a startup, in a new round of investment, reducing the share of a previous investor in the company in such a way that it raises new capital at a lower valuation. 

Let's look at an example. In a $1,000 company with 100 shares, an investor owns 10 $10 shares for a total of $100. When another 100 issuance of shares at $10 are issued as part of a new shares issue, the previous investor's 10 percent share in the company with a post-money valuation of $2,000 is immediately diluted to 5 percent, so the value of his investment has not changed. At the same time, if the new issue were to take place at a price of, for example, $8 per share, the entire stock of 200 shares would be worth only $1,600 - i.e., the investor's original 10 shares would also be repriced.

In such a case, the protection takes place in such a way that before the new capital raising takes place, the previous investor must be offered shares at a discounted price in order to retain his share of ownership.

In the case of venture capital investments, anti-dilution protection is a standard procedure. The protection against dilution is usually included in the clauses of the preference shares and the term sheet, and it comes into effect if the new issuance of shares or capital raising takes place at a lower company valuation than the one at which the investor bought in.

Dilution can also occur if holders of share options (those who can buy shares from the company at a predetermined price), such as employees, board members or other beneficiaries, exercise their options, i.e. exercise the buy option. In some cases, the company can get extra cash, which increases the value of the company proportionally, thus offsetting the dilution, but this is relatively rare. Such a case could be, for example, a merger or a share exchange.

Dilution poses a threat mostly to venture capital investors, which has two typical solutions: in the case of "full ratchet", i.e. full compensation, the previous investor's share of ownership is recalculated as if he had also bought in the new investment round at a specified price. In this case, the founders are at a disadvantage, as they have to hand over a given proportion of their share as compensation. The other method is the "weighted average", when the existing shares are priced at some intermediate value between the old and the new investment value.